UK: Deloitte Banking And Capital Markets Insight

INTRODUCTION

Welcome to the January 2009 edition of Banking and Capital Markets Insight, which focuses on technical issues currently coming out of the banking, capital markets, securities and fund management arenas. Our focus for this edition is inevitably on issues arising from current market events, the regulatory and tax responses to them, and potential developments in 2009.

Our four pieces cover the following areas:

• Mike Williams on the likely trends in the coming year, in terms of competition and high level regulatory developments, in the London markets;
• Clifford Smout and Kari Hale on the Top 10 regulatory developments and priorities in 2009, both in the domestic and international regulatory arenas and across financial and conduct of business rule developments;
• Eric Wooding on the longer term strategic thinking of the Basel Committee, and the proposed building blocks to manage capital, liquidity and risk more effectively and to increase the level of capital buffers, stress testing, etc.; and
• Wayne Weaver and Kate Craven on the proposed changes in the pre budget report on the taxation of foreign profits and the treatment of controlled foreign companies, both of which are likely to be important changes for UK taxable companies. We look forward to your comments on this edition.

Mike Williams
Editor

LOOKING AHEAD TO 2009

I would normally include some comments about the closing year in my end of year review and looking forward article, but for many firms, as the year draws to a close with yet more financial turmoil, it will be a year they would rather forget. Not all will share this view – for some organisations this year has been another profitable one and some others will feel that it has been a year when their conservative management values and wariness of complex products has been supported by market events.

So what does 2009 hold? Clifford and Eric have covered detailed regulatory issues in this issue, so I want to set out my own thoughts on some aspects of the themes raised in the excellent report produced by the Review Panel led by Bob Wigley of Merrill Lynch, which has been convened by Boris Johnson as incoming Mayor of London, to review London's competitive positioning in the changing world economic environment in the next 5 to 10 years. I also want to cover some higher level regulatory and market issues.

In the CBI's 2008 London business survey, it was interesting that a third of respondents saw London's status as a world city diminishing over the next five years, compared to 13% of respondents two years ago. London has undoubted pre-eminence in areas such as cross-border bank lending, foreign exchange, OTC derivatives trading and marine insurance, and it remains the largest Eurozone financial centre by some distance ahead of Frankfurt and Paris. It currently feels, however, as if the City could lose its position relatively easily due to factors that include:

• Intelligent And Risk Focused Regulation. Ironically, the European regulatory landscape, which the FSA has helped to champion and which has helped to build the foundations of a single capital market in Europe, has taken away from London's regulatory responsiveness and flexibility, as more and more of the FSA's regulatory responses are hard coded by EU Directives. It has been noticeable in the current difficult period that the US regulators have had more ostensible capability to flex individual regulatory provisions than the FSA.
  
  As we go into a period of continued difficult trading, the nimbleness of thought of the FSA and its ability to reinvigorate its reputation for excellence of regulatory oversight will be essential in maintaining London's position. While offshore locations may have allure to some more mobile businesses, the badge of UK regulatory oversight is still an important "seal of approval" for the majority of firms. In 2009, maintenance of adequate of capital and liquidity and prudent risk governance will be essential for all firms, and there will no doubt be more market shaping events as access to these continues to be restricted and events in the real economy catch up with the smaller and medium sized players. Again, the skill of the combined oversight of the FSA, the Treasury and the Bank of England when firms get into difficulties will be paramount in maintaining London's world standing.
• Access To A High Quality Talent Pool. One facet of the current crisis which is different from previous recessions is the mobility of individuals away from London to the Middle and Far East or elsewhere in Europe, where prospects for higher economic growth are better and personal tax regimes potentially more attractive. The benefits of living in London are not a given, and there will be a number of individuals who will find the expense and day-to-day stresses of living in London hard to justify to themselves in the downturn. As the Review Panel rightly identify it is the quality of London's graduate and post-graduate courses, which will continue to help to draw talent to it and differentiate it from other European centres. Financial services as a career may in itself well be less attractive to top quality graduates in the short term, and the fight for talent will intensify significantly in 2009. Firms may well find themselves paying top dollar to recruit new resource, a difficult sell to existing staff whose own pay rises are likely to be restricted.
• Reliability Of Infrastructure. The infrastructure of London, from the crowded roads and airports to the accessibility of data centre processing capabilities, is becoming a limiting factor in London's continuing growth as a financial centre. I expect that in 2009 forward looking firms will continue to build their capability to trade and settle business most profitably in London and that there will be continuing initiatives to offshore more back office and support activities or to move them to lower cost UK locations. Firms will, however, want to keep close to the main exchanges and clearing houses for their trading activity to maximise latency of processing and speed of access to exchange for growing areas of business such as direct market access. In 2009, regulatory and market pressures will also drive to completion the initiative to set up a central clearing house for credit derivative activity, and firms will actively seek out the most stable platforms and those with the most advantageous calculation of margin calls for their trading.
• Consistency Of Tax Regime. The personal and corporate tax regimes in the UK have been subject to seemingly continuous revisions in the past few years, and in many ways certainty of tax treatment has a greater importance to individuals and firms, although the absolute rate of tax is of course paramount. 2009 is hopefully the year when a better balance is struck between the need for the Government to flex tax provisions to improve tax take with a better recognition of the need for early consultation with firms as far as is possible. Certainly, 2009 is the year when large corporates are more likely to exercise their option to move their business to a more favourable tax jurisdiction, when UK growth prospects are at a lower ebb and cost inflation is likely to increase.
• A Strong Champion. While there are a number of excellent bodies which currently support London's overseas profile and positioning, the idea of creating a single Financial Services Promotion Board to champion London's interests is a positive development. I predict that 2009 will be the year when finance industry leaders perceive more benefit in associating themselves with the promotion of London's interests as a financial centre, as the competition from overseas market places intensifies.

2009 is likely overall to be a year of consolidation and no doubt there will buying opportunities for acquisitive organisations. It will also be the year when firms can maximise their opportunities, when we do finally emerge from the current difficult market conditions, by reorganising their affairs to get the best advantage from cost rationalisation, relocation of non-key functions, the improvement of core IT processing and security procedures, and by making the most of existing regulatory capital by reviewing Basel model permissions and processing inefficiencies.

This is a very demanding agenda but will pay dividends for those firms that take it forward proactively. 2009 is likely to be an equally significant year as 2008, but will focus more on the governance and infrastructure issues of individual firms and the market place. Best wishes to all of our readers in tackling them.

Mike Williams

WHAT'S ON THE REGULATORY RADAR FOR 2009?

2007 was the year the "music stopped" and the credit crunch began. 2008 was the year its full impact became apparent, with market liquidity severely impaired and many firms across the globe either failing or being bailed out by government intervention. System-wide recapitalisation measures have been unveiled in many countries, and liquidity provision by central banks overhauled. Suddenly, developments in financial markets, and financial services more generally, are front-page news.

So what about 2009?

At one level it's still too early to draw the full lessons from the banking crisis, not least because we still don't know if we are "there yet" or whether there is more to come. Questions that economic historians will look to answer in due course include whether (and if so why) so few people seem to have fully appreciated the scale and nature of systemic risk that had built up in the global financial system.

Put another way:

• was this the "one in 200 year" event that current regulatory practice is explicitly designed not to prevent;
• or was it preventable and/or exacerbated by inappropriate regulation;
• or was it a bit of both?

Of course both supervisors and policy makers have to respond to the challenges of these troubled times without the benefit of such perspective. In that context we have identified a short list of the ten highest impact and most likely immediate priorities for regulation, which we have been using since mid-year both as an analysis and communication tool.

The Top 10

In the table below we set out these priorities, divided into three columns. The international issues and themes in part reflect those identified by bodies such as the Financial Stability Forum. The domestic issues represent either ongoing priorities within the UK, or a response to particular issues resulting from Northern Rock and subsequent cases.

Taking each in turn:

The Top 10

• Liquidity – Banking supervisors both in Europe and at the Basel Committee have produced detailed qualitative guidance, and this has been supplemented in the UK by the recent FSA paper, setting out a more structured approach to individual liquidity assessment, and noting issues related to intra-group flows. A major issue for 2009, with potentially significant effects on business models.
• Capital – A number of detailed changes are under discussion – e.g. for structured products and incremental risk in the trading book. There will also be more work on the definition of capital itself. Other changes are possible – e.g. counter-cyclical capital requirements such as "dynamic" provisioning. And at the most basic level, if the Basel "8% capital ratio" was appropriate in the mid-80s, is it still so now that more assets are traded, and markets and valuations are more volatile? A discussion of huge importance, not least to finance ministries that have had to recapitalise firms that were regarded previously as well-capitalised.
• Disclosure, Valuation And Accounting – There have been several clarifications and amendments to the valuation rules, and also proposals to extend disclosure further – but with less attention paid as to how to make such disclosure "better" rather than simply "longer". Both these areas are likely to continue to feature extensively in the regulatory agenda for 2009.
• Financial Crime – It is often only when markets and economies turn down that past malfeasance comes to light, either by employees or external parties, and when markets are volatile the potential gains from market abuse are at their highest. This is a significant risk, and one that may be under-played at present given the predominance of prudential issues, which may become more prominent once the prudential crisis is seen to be blowing over.
• Treating customers fairly – While the formal deadline for "embedding" TCF was 31 December 2008, this remains the driving force behind a whole range of issues, such as conduct of business and charges in both retail banking and mortgage lending, sales of payment protection insurance, and the more fundamental restructuring implied by the retail distribution review. Given the injection of government cash into banks, these issues may become still more important in 2009.
• Information Security And Data Privacy – The FSA and the Information Commissioner are working closely together – losses of personal data raises both financial crime and TCF issues. A long-standing source of significant reputational risk, which potentially may have a heightened impact for banks in which the taxpayer has a stake.
• Deposit Protection And Special Resolution Regime – The core of the new UK banking bill. Deposit protection levels have also recently been raised in many overseas countries, and there are attempts to legislate for much more rapid pay-outs. Recent cases in the UK give some idea as to how the new regime might work, with the government accepting that it will be important not to disrupt arrangements on netting for example, and also guaranteeing some "uninsured" deposits over £50k. The regime may also be extended to investment firms that hold client assets/money. A major issue on three grounds – direct cost of such payments, indirect costs of systems enhancements and any unintended impacts on third parties.
• Stress Testing And Scenario Analysis – This is needed so as to identify if "fully hedged" positions remain so in all circumstances, and what combination of events might "break the bank". It is also important to re-examine what a "1 in 200 year" event would look like, given recent history, not only for capital but also liquidity, and operational resilience. In some ways this is more a means to an end rather than a priority, but it is important – it includes "standard" business continuity issues.
• Rating Agencies – Enhanced oversight of the agencies is likely, with robust controls over conflicts of interest. There is a risk of knock-on effects on EU banks and/or investors unless the proposed legislation is carefully drafted.
• Reforming International Regulation – In some countries or regions there may be pressure to merge or otherwise "rationalise" the regulatory structure – although in e.g. the US some of this has happened by default: there are no longer any large independent brokers. Greater international collaboration – e.g. via colleges – is also likely, though some recent events have shown that national interests are not always fully aligned, especially in a crisis. Potential efficiency gains for international groups from such reforms, but in an insolvency the position of the individual legal entities in a group may differ, and regulatory arrangements will need to reflect this reality.

What Else May Be On The Radar?

There will certainly be pressure to look again at governance and risk management practices, which go beyond issues such as stress-testing, to encompass bonuses and executive compensation (where in many countries there is a political imperative to act), senior management responsibility and accountability, and the qualifications and experience of Board members.

In this context more independent testing and assurance work may be needed, to demonstrate both that the relevant controls are fit for purpose and that they are operating as intended.

OTC Clearing And Settlement is receiving great attention, both in Europe and the US, as a means of reducing global systemic risk.

Policymakers have emphasised that they will be looking again at the regulatory Perimeter – which players should be subject to prudential oversight (and which to conduct of business rules), for instance in the "shadow banking system". This will entail a review of the regime applied to players such as hedge funds and private equity firms.

And finally regulators will be under great pressure to demonstrate and apply market knowledge, independence and professionalism, and to intervene decisively and rapidly, both on the ground and in advancing the policy debate. Supervision is likely to become more intrusive and its impact on the operations and strategy of business may be just as profound as the likely changes in the policy landscape discussed above. It should all make for an interesting, but very challenging, year...

Clifford Smout and Kari Hale

BASEL'S LONGER TERM STRATEGY

While the immediate problems posed by the deepening economic crisis remain their priority, regulators are already working on the longer term issue of how to repair and strengthen banking regulation and supervision across the globe. For anyone seeking to keep abreast of developments on this issue, the Basel Committee's recent announcement of its "comprehensive strategy" to address the lessons of the banking crisis is essential reading.

The Committee states that its main aim is to strengthen capital buffers, contain leverage arising from both on and off balance sheet activities, and promote stronger risk management and governance in banks.

It identifies the following "key building blocks" of its strategy:

The Chairman of the Committee (Nout Wellink, President of the Dutch central bank) put some flesh on these bare bones in a recent speech. The main points are summarised below.

Strengthening Capital Buffers

The Committee's plan in this area has four main elements:

• to strengthen the risk capture of the Basel II framework, including the capital treatment for off-balance sheet exposures and securitisation (for which proposals are to be issued in early 2009) and the capital framework for the trading book (proposals for this were issued in July and are summarised in the box on page 6);
• to consider the issue of the quality of capital resources and in particular to review the key elements of Tier 1;
• to consider ways of dampening the potential procyclicality of the Basel II framework by promoting strong capital buffers above the minimum requirement in the upturn and allowing those buffers to be used in the downturn; this work includes assessing ways to strengthen prudential filters, promote through-the-cycle provisioning and contribute to the strengthening of accounting standards for financial instruments;
• to review the need to supplement risk-based prudential and risk management approaches with simple gross measures of risk, a key objective being to provide a further check on banks underestimating risk and building-up excessive leverage in the upturn.
  
  

Strengthening Liquidity Risk Management And Buffers

The Committee's strategy is two-fold:

• to establish a process for ensuring the implementation in practice of the principles set out in its recent paper Principles for Sound Liquidity Risk Management and Supervision;
• to develop more consistent benchmarks for sound liquidity at global banks, including liquidity cushions, maturity mismatches, funding liquidity diversification, and stress resilience.

Strengthening Risk Management Practices

The Committee proposes to issue additional guidance "around the new year" in areas where lessons have recently been learned, particularly securitisations, management of exposures, whether or not contractual, to off balance sheet vehicles, stress testing, management of firm-wide concentration and sound valuation. In addition the Committee proposes using the supervisory review process (Pillar 2) to promote better governance and risk management, including achieving a better alignment between long term risk management and the incentives created by compensation schemes.

Strengthening Counterparty Credit Risk Practices

The Committee plans to review the treatment of this risk under all three pillars of Basel II with a view to helping individual banks and the system better withstand the failure of one or more major counterparties. The Committee regards the work in this area as part of a broader effort to assess the scope of regulation and oversight beyond the banking sector.

Strengthening Bank Resolution And The Supervision Of Cross-Border Banks

The Committee has set up a group to assess key issues and global incompatibilities in the resolutions of global banking groups with a view to developing a better understanding of the challenges that can arise and how to manage them. In addition, the Committee aims to promote effective supervisory colleges at cross-border banks.

Strengthening The System-Wide Approach To Supervision

The aim is to embed supervision of the individual bank in a broader context of seeking to make the overall financial system more resilient to stresses. The Committee proposes a number of practical ways of advancing to this goal, including counter-cyclical capital regulation, co-ordinated global reviews (e.g. of lending standards), an assessment of the gaps in global regulations, assessing better ways to promote risk management and establishing stronger links between the objectives of central bank liquidity operations and liquidity regulation and supervision.

Assessment

As a response to the specific weaknesses revealed by the current crisis the Committee's strategy appears to contain few surprises or obvious gaps, except perhaps in relation to the trading book. The approach there – essentially to continue to rely on banks' models, albeit more comprehensive ones, supplemented by additional valuation guidance and simple gross risk limits – seems rather an underreaction given the massive role of imprudent trading book activity in the current crisis.

One key issue the strategy does not address is the extent to which, if at all, mark-to-market gains (which are often temporary) and mark-to-model gains (which lack regulatory "credibility") should be included in Tier 1 capital and hence be permitted to support leverage and risk in both trading and banking books, not to mention dividends and bonus payments. The fact that the Committee makes no mention of this issue, namely the procyclicality of accounting in the trading book, is the more surprising given the Committee's explicit mention of dynamic provisioning as a way of dealing with the equivalent problem in the banking book.

But the main concern with the Committee's strategy is not its response to the specific policy problems it can see in its rear view mirror. It is rather that the strategy contains little on how the Committee proposes to change its way of working, and perhaps its membership, to address new problems, currently "unknown unknowns", that no doubt will arise in the future. The Committee's strategy contains little to build confidence that it has addressed the potential organisational shortcomings that caused it to miss the risks posed by the rise of the shadow banking system.

Eric Wooding

PRE-BUDGET REPORT – TAXATION OF FOREIGN PROFITS

Included in the Pre-Budget Report of 24 November 2008 was a long expected announcement in relation to the taxation of foreign profits in the UK.

In essence the reform package announced will introduce an exemption from UK corporation tax for foreign dividends received by UK companies, it is, however, not yet clear from which date this exemption will apply.

Additionally the announcement indicated that the rules requiring Treasury consent to be sought when UK companies undertake certain transactions, such as permitting an overseas company over which it has control to create or issue shares, will be abolished. These rules will be replaced with a requirement for post-transaction reporting of transactions with a value in excess of £100m.

Both of these changes are positive news for UK outbound groups, however the announcement also contained some potentially bad news, namely:

• A worldwide cap on the amount of interest that can be deducted for UK tax purposes will be introduced (the aim being to prevent a company putting more debt in to the UK than the group as a whole has borrowed).
• The current anti-avoidance rules for loan relationships will be extended.
• The controlled foreign company exemptions currently available to overseas subsidiaries will be reduced.

HM Treasury estimates in the Pre-Budget Report indicate that although the Treasury will gain additional tax revenue from UK companies as a result of these rules in the tax years 2009/10 and 2010/11, it will begin to cost the Treasury in 2011/12. There is no split of the impact between the various measures.

Controlled Foreign Company ("CFC") Rules

As mentioned above, the Pre-Budget Report will result in the removal of some of the CFC exemptions.

Currently where a company would otherwise be considered to be a CFC but distributes 90% of its profits back to the UK by way of a taxable dividend within 18 months of the end of its accounting period, it is considered to be following an acceptable distribution policy and is thus exempt from the CFC rules. As foreign dividends will now be exempt from UK corporation tax this exemption no longer makes sense and will therefore be abolished.

Additionally the current legislation provides that where a company is resident in an overseas jurisdiction and is subject to a lower level of taxation, it will be exempt from the CFC regulations where:

• 90% of its income is derived from companies it controls.
• Those companies are resident in the territory of the holding company.
• Those companies are not in themselves holding companies but are otherwise engaged in exempt activities.

This is known as the holding company exemption. The Pre-Budget Report indicates that this exemption will also be abolished. This is likely to hit many groups that have overseas holding companies for normal commercial purposes. Consideration will therefore need to be given to whether or not any of the other exemptions are applicable or if it not if it will be necessary to apportion the profits to the controlling UK company.

Next Steps

Wider reform of the CFC rules is expected, however no timetable has yet been set for this by HMRC. It is therefore unlikely that any reform will be implemented prior to 2010, and as this is likely to be election year it is also unclear what impact this may have on future CFC reform.

On 10 December 2008, HMRC issued the foreign profits draft provisions and accompanying explanatory material. Comments should be received by HMRC by 3 March 2009.

Wayne Weaver and Kate Craven

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.